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M&A deals the size of BAT and Reynolds can often see value go up in smoke

17/11/2016

Andrew Evans

Fund Manager, Equity Value

Recent news reports suggest US tobacco giant Reynolds has “stubbed out” the proposed buy-out deal that would create the world’s largest cigarette company because, whisperings of “sources familiar with situation”, say that the $47bn (£37.5bn) currently on the table from its UK partner British American Tobacco (BAT) is not enough money. Here on The Value Perspective, we would argue that depends on your point of view.

As a rule, merger and acquisition (M&A) activity is not something that tends to inspire huge confidence in us but, rather than prejudge this particular deal, we had done some calculations based on the $47bn offer. Since our maths was on the back of a fag packet – obviously – we repeat it here just in case it helps out BAT’s management as they weigh up whether to go back to Reynolds with a higher number.

BAT already owns a 42.2% stake in Reynolds so its $47bn offer related to the remaining 57.8% – $20bn in cash and the rest in shares. That price-tag would not be enough to elevate the deal into an all-time M&A top 10, which is still led by Vodafone’s $202bn takeover of Mannesmann back in 1999, but it would sneak it into a top 10 chart of the largest bids made by a UK business for a foreign company.

As we have discussed before, in articles such as Merger will out, M&A deals have a nasty way of working out badly for the companies doing the merging or acquiring – with, broadly speaking, two out of every three deals destroying value. Still, one might presume BAT knows a bit about valuing a tobacco business – especially one it already owns a big chunk of – so what are the odds, even at $47bn, this deal could buck the trend?

One rule of thumb for whether an M&A deal is any good or not is to consider whether the present value of the resulting synergies would be greater than the premium being paid. The cost synergies associated with the Reynolds merger were estimated by BAT to be around $400m – a relatively modest sum and one that would still need to be verified following further engagement with its target.

Still, it is the best figure we have and, by applying a multiple of 10x, we arrive at a present value for the synergies of $4bn. By way of comparison, BAT was looking to buy the outstanding Reynolds shares at a 20% premium, which works out at some $8bn. As we said, this is only a rough way of gauging a deal but, with the premium double the present value of the estimated synergies, it is not a promising indication.

A method of judging M&A success that has been gaining a lot of currency among analysts is the extent to which a deal is ‘earnings accretive’ – that is to say, how much it helps a business grow its earnings. At $47bn, the deal certainly looked to be earnings accretive pretty quickly – but that tends to be so in most M&A, which is why, here on The Value Perspective, we prefer to consider deals in terms of returns accretion.

At present, with net operating profit after tax of £3.7bn on invested capital of £22.7bn, BAT boasts a return on invested capital (ROIC) ratio of 16.5%. At the same tax rate, Reynolds makes $4.5bn in net operating profit after tax, which – given the $90bn enterprise value implied by BAT’s $47bn offer for the shares it does not already own – points to an ROIC of 5%.

Far from being returns accretive, then, even at $47bn, the deal looks as if it would be quite damaging to the merged entity’s overall ROIC. As we said, perhaps BAT has a better idea of what this particular 57.8% tranche of shares is worth but, to match that 16.5% ROIC, Reynolds would need to make $14.8bn in net operating profit after tax – more than three times its current number – which is quite some growth assumption.

Let’s now take a different tack and see what history tells us we might expect from an M&A deal of this sort of stature. Some – the likes of Anheuser-Busch InBev and SABMiller, Royal Dutch Shell and BG Group, and Verizon Communications and Verizon Wireless – have taken place too recently for anyone to be able to draw any meaningful conclusions.

Go back a few years further, though, and for every Glaxo Wellcome and SmithKline Beecham or Royal Dutch Petroleum and Shell, you will find many more – the likes of ABN Amro and Royal Bank of Scotland, AT&T and BellSouth, Sanofi and Sanofi Aventis and of course the tech boom and bust pin-up deals of AOL and Time Warner, and the aforementioned Vodafone and Mannesmann – where the resulting business failed to outperform the market in its post-mega-merger years.

Given all that, it will be fascinating to see if BAT decides to attempt one last drag or grinds the stub under its foot and walks away.

Author

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst.

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